Tuesday, February 1, 2011

In the previous post in this series, I made the statement: "The government cannot print money; only the Fed can do that." And then I asked: why are things that way? What is it about central banks that allows them, instead of the government "of the people, by the people and for the people" to decide how much money shall exist at any one moment?

These are not new questions. The truth is, that when our government was founded, it did have the sole power to create new money -- by minting coins from gold and silver it purchased from private miners of and dealers in those metals. But there has ever been a temptation, among those who appreciate the miracles of central banking (where new money can be created, as I explained, out of thin air), to take the power of money creation out of the government's hands, and to leave it to the all-knowing bankers.

Alexander Hamilton was foremost among our founding fathers to urge the creation by Congress of a national bank. Such an institution would have the power not just to coin money out of real gold and silver, but also to create it by printing and distributing paper notes -- backed by the "full faith and credit of the United States government." It would draw its strength and power from the fact that it acted as the official bank to the government, and was where the Treasury deposited all its receipts from custom duties and excise taxes (remember --for the first 124 years of our government, it managed to pay its expenses without the help of any national tax on incomes).

The first such national bank, with Hamilton's blessing, was chartered by Congress in 1791. Prior to its organization, Hamilton, as George Washington's first Secretary of the Treasury, had been instrumental in establishing the credit of the new nation by arranging for a loan of the (then enormous) sum of $200,000 in 1789 from the Bank of New York, itself founded in 1784 by Hamilton with Aaron Burr (the man who would eventually kill him in a duel). That private bank was able to manage a transaction of that size (note that it had been capitalized with initial shareholder contributions of $500,000 -- after a war!) only with underwriting from another central bank: the Bank of England, with whose country the war had been fought. (Such are the powerful forces of banking that they are willing to finance anyone who has a chance of repaying them, even if they are current or former enemies.)

And thus was our first private debt created (debt held by just one entity), which then became public debt in 1791 (debt held by members of the "general" public -- hah!), upon the formation of the First National Bank of the United States, and its exchanging of the government's theretofore private warrants for publicly tradable paper notes, secured by the government's deposits with the bank. We have been hooked on such paper debt (notes) ever since.

It took creative minds like Hamilton's to get the nation accustomed to the eternal cycle of borrowing from banks of money they created in part out of nothing, followed by repayment of that borrowing to the banks with interest. As this article explains:

Now the creditors of the United States, which included the Bank of England, wanted to be paid the interest on the loans that were granted to the United States. So Hamilton came up with the bright idea of taxing alcohol. Consumers resisted, so President Washington sent out the militia to collect the tax — which they did. That episode became known as the Whiskey Rebellion.

Only on January 8, 1835 did that determined man of the people, President Andrew Jackson, manage to pay down all of the then outstanding national debt. For the first and only time in its history -- but for just one day -- the national public debt of the United States stood at zero. And President Jackson carried through on his principles by vetoing a renewal of the charter of the Second Bank of the United States in 1836. He followed this act with an executive order that the Treasury accept no more paper notes (from state-chartered banks) in payment for purchases of public land. The resulting shock to the system of private banking that had grown up in the shadow of the national bank, and which now had no "bank of last resort" to back up their speculative issuance of paper notes when their depositors demanded redemption in specie, led directly to the "Panic of 1837." The failure of many private banks, and the resulting deflation in available currency -- went on for six years, and probably prevented Jackson's successor, Martin Van Buren, from achieving a second term.

What does this history teach us? That there is an inevitable connection between too much borrowing on the part of the government, and too little creation of wealth by the private sector, as a result. Let us see in greater detail why this is so.

When the government borrows money -- whether from private or central banks -- it pledges to repay that debt, plus interest. But how can the government accomplish that repayment, if itself creates no new money to do so? Answer: it has to make the repayment of principal and interest out of either current revenues or current additional borrowing.

Everyone can see that the latter alternative is a dead-end street. It is folly to repay old debt by borrowing more money: the compounding of interest will require ever more and more borrowing just to keep apace, and hence such a practice is unsustainable in the medium run, to say nothing of the long run.

All right, so the repayment of debt plus interest must occur out of current revenues, if the government is not to become insolvent. But what are current revenues? Answer: they are money sucked out of the consumer economy -- by taxes, fees, fines, duties and imposts, and the like (the government has become infinitely creative). While "creative" in tapping new sources of revenue, however, the government does not create any new money. Instead, it has to take money from others in order to operate. And in doing so, it creates nothing: no new wealth -- zero, zip, nada. It simply pays its operating expenses, including the repayment of old debt, with other people's already earned money that has been exacted from them for that purpose. (Or, if it spends the money on new highways and bridges, it can help to create new wealth, but only at the expense of the private sector's making those decisions as to where best to invest capital. And note that most of the government's spending on new infrastructure comes from borrowed money again, i.e., bond issues.)

As I explained in the earlier posts, the only ones who get rich off this scheme are the bankers. The Fed itself makes billions and billions of dollars in profit every year on its lending money, which it creates out of thin air at zero cost, to the government and to other banks. By law, it turns over the profits at the end of every year -- after paying for all its expenses, including handsome salaries and the upkeep of expensive, marble-lined buildings -- to the United States Treasury.

Isn't that a nice, convenient loop? The Fed first creates the money at no cost to itself, and lends it to the Treasury, and other banks, at interest. The Treasury borrows not only from the Fed, but also from bond dealers and from the general public, to all of whom it pays periodic interest on what it has borrowed. By taking taxes from us, the Treasury is able to pay that interest (plus principal, as its bonds fall due) in part back to the Fed, who deducts its operating costs, and then deposits the surplus in the U.S. Treasury. It's all a shell game, played with paper money and promises to pay. But meanwhile, the private banks collect interest on all that federal borrowing, and report profits to their shareholders (as long as they stay away from bad investments).

Perhaps by now you have seen the Achilles heel of the entire system. Or perhaps you have been misled to think it cannot exist, since everything runs so smoothly. Here, however, is the fundamental flaw in the current system: unless "new" money is earned with which to pay the interest on borrowed principal, the borrower has to default. And the new money so earned has to come from somewhere. If every dollar of principal borrowed goes to repay that principal, then where does the extra money to pay interest on the principal come from?

Answer: it has to be created -- either in paper by printing, or out of "thin air" by central or private banks in creating instant electronic credits, or else by the adding to the total supply of hard money (newly minted gold and silver). There are no other ways -- think about it for a minute.

To the extent that the economy is not in any condition to produce new goods and commodities from the earth's storehouse of natural resources, the first two methods are a zero-sum game. For every new dollar created in such a fashion, when their creation outpaces the supply of new goods, we all suffer by a proportionate decline in the value of our money to purchase existing goods. That proportionate decline in the value of our purchasing power -- whose effects since the Fed's creation in 1913 are graphically illustrated in the picture at this post -- is another way of saying inflation.

Thus we have closed the circle: given our current crazy monetary system, in which banks alone get to create the money, government borrowing is inevitably linked to inflation -- an artificial increase in the supply of money. That increase in money, together with the government-induced distortions in the economy by subsidizing this activity and by taxing that one, result in over-investment in some sectors of the economy, and underinvestment in others. (The entire lobbying game is structured to obtain favorable results by skewing the lottery of such "public policy" decisions in their clients' favor, and to the disadvantage of their clients' competitors.) Bubbles are created in certain types of favored investments (adjustable rate mortgages, anyone?), which inevitably burst and, through losses, bankruptcies and foreclosures, lead to a decline in the supply of money, called deflation.

The Fed is currently engaged in a frantic program of inflating the money supply, by purchasing failed ("toxic") assets from businesses and banks, in order to counter the deflationary effects of all those failures. Whether it can succeed in doing so without igniting hyperinflation is, at the moment, anyone's guess. Not even Ben Bernanke can forecast the results of the Fed's current inflationary policies, because there are too many hidden variables which could affect the course of events, one way or the other.

But if too much inflation pours into the economy at one time, confidence in the monetary system erodes -- and if it erodes too fast and all at once, hyperinflation results. Inflation and deflation are the Scylla and Charybdis between which the Fed must successfully navigate, if we are to emerge from the current recession / depression (choose your label; it does not matter). To do so, it must maintain confidence in our fiat monetary system, by not undermining the expectations of those who depend on it for their livelihoods.

And so, I hope you can see a bit of what it took to get us where we are today. We began borrowing almost the first day the government opened for business in 1789. And because the government needed funds with which to commence operations, there was already in place (surprise! surprise!) a bank ready, willing and able to lend those funds to it, at interest. And that has been the story ever since, almost without interruption -- except that now, the level of borrowing is higher than it ever has been before, and nearly double what it was just three years ago. (And Congress has before it a proposal to increase the debt still more by March of this year.)

Things cannot continue as they have -- money cannot continue to be created out of thin air, with no corresponding wealth to back it up. Common sense tells anyone as much.

But if we cannot continue borrowing and spending ever more and more, then what? Do I really need to spell it out? Either the government lives within its means, with no new borrowing until national debt is paid down to a sustainable level, based on national income, or else we have to abolish or severely restrict the Federal Reserve System, and take away its unfettered power to create money out of nothing. (There may be other alternatives out there, but the people proposing them are not having much success in being heard, and I for one am not aware of any.)

The first alternative is straightforward, and requires no discussion: tighten our belts, stop runaway spending, and resolve never to go there again. It is the second alternative which intrigues me, and which I shall take up in a later post.

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